How Did High Flyers Turn into Soul Searchers? Maxim Analyst Jason Kolbert on the Highs and Lows of Biotech Valuations

After soaring more than 56% last year, the NASDAQ Biotechnology Index is down almost 15% in March. In this interview with The Life Sciences Report, Jason Kolbert of the Maxim Group points to increased approval rates and a better economic and regulatory environment as the fundamentals behind a revaluation that has occurred in the sector. Kolbert also reflects on recent concerns about pricing and policy changes that have triggered what he considers a normal, healthy correction in an otherwise robust and intact sector.

The Life Sciences Report: In a recent Equity Research Industry Report, you said, "We believe a revaluation of the sector is underway." What is causing this revaluation and what does it mean for investors?

Jason Kolbert: The value driver in the biotech sector is better products with higher efficacy and fewer side effects, which in turn drives a higher rate of regulatory approvals. Historically, the biotechnology industry and the stocks in the space have had the essence of gambling high risk and high reward. A company's success and performance largely hinge on its ability to develop a pipeline of drugs and to achieve regulatory approval [i.e., survive the regulatory environment in this case the U.S. Food and Drug Administration [FDA]]. The fact that the number of FDA approvals for the past three years has been trending positively is a great sign for the biotechnology space. Forbes reported that the FDA has quickened its pace of new drug approvals, approving an average of 32 new drugs annually over the past three years, significantly higher than the historical annual average of 24 from 2000 to 2010. We believe these higher numbers may continue over the next few years.

TLSR: Was the upward trend based solely on the number of drugs being approved?

JK: Industry success hinges on much more than just quantity. The quality of drugs being approved makes a huge difference.

TLSR: What are some examples of drugs that could be an improvement over the current standard of care?

JK: Industry experts and the management teams of the companies we follow tell us that recently approved drugs like Gilead Sciences Inc.'s (GILD)Sovaldi and Medivation Inc.'s ($MDVN) Xtandi, as well as those still in the pipeline, have the potential to offer significant improvements over existing alternatives, and bolster both industry sales and investor confidence. In the cell therapy space, we believe that Mesoblast Ltd.'s ($MEOBF) ($MBLTY) Revascor has the potential to completely change existing treatment paradigms.

TLSR: Why does it seem that more of the drugs in the pipeline today are targeting rare diseases?

JK: This is an important shift in the drug development field. These drugs are granted special status by the FDA. The result is limited competition, enhanced intellectual property life and an increase on the return on investment. Furthermore, these drugs are able to access a more favorable regulatory pathway designed for therapies that represent a significant advance over standard of care, or an overall benefit to society. The result is an accelerated development-and-approval timeline to market. With a growing portion of drugs fitting into this category, we expect to see further outperformance in the sector.

TLSR: Why have we seen more merger-and-acquisition [M&A] activity recently?

JK: The recent $25 billion acquisition of Forest Laboratories Inc. ($FRX) by major specialty pharmaceutical company Actavis Inc. ($ACT) may be partly responsible for the increase in valuations for related companies, such as Teva Pharmaceutical Industries Ltd. ($TEVA). A growing proportion of these large-cap pharmaceutical and biotech companies are engaging in M&A activities as they seek out size and achieve efficiency of scale. The large caps are often focused on smaller companies in the rare disease drug arenas for the reasons we've already mentioned, to help compensate for projected revenue losses resulting from the recent expirations of key patents.

TLSR: The biotech initial public offering [IPO] market has been active in the last year after some lean years for new public company launches. What is behind that change?

JK: We saw 37 life science companies go public in 2013, and 24 IPOs have already been underwritten this year. We see several underlying drivers. First, M&A activity has reduced the number of publicly traded small and or independent biotechnology companies. This limited supply has led to a high demand for small- and mid-cap names and, in turn, driven an oversubscription of many of the recent offers. This only encourages an already robust IPO market.

We also note that generalist fund managers and even individual investors have been increasing their exposure to the biotechnology industry, driven by an increased risk appetite and eagerness to chase high-return profiles. The rise of stocks like Pharmasset Inc. [acquired by Gilead] helped drive this trend. The success of Intercept Pharmaceuticals Inc. ($ICPT) is another example of the risks and rewards that the sector offers to investors [which make it unique in the field]. The significant outperformance of the sector and the IPOs over the past year have caused generalists who otherwise normally shun the volatility of the space to get involved, generating an even greater demand for new biotechnology IPOs.

Last but not the least, the Jumpstart Our Business Startups [JOBS] Act allows companies to prepare IPOs and test the waters to determine interest. This is one of many factors that have effectively reduced risk for companies looking to go public. The act has been a catalyst for a large number of the offerings this year offerings that have been accumulating in the pipeline over the last few years as companies had difficulties accessing capital markets. As such, an economic recovery, a favorable regulatory environment and the JOBS Act have fostered a robust IPO marketplace in the sector.

TLSR: Has all of this good news come to an end? What has happened over the last week or so to cause the sharp pullback we saw in the space?

JK: I think we are seeing a normal, healthy correction. Markets and sectors don't go straight up. Biotech markets got a shock when letters from congressmen questioned the price of Gilead's Sovaldi as an expensive new drug for hepatitis C. What these letters fail to take into consideration is the overall efficacy and pharmacoeconomic value of new therapies like Sovaldi, which work better and have fewer side effects than predecessors.

TLSR: When can we expect a return to upward valuations based on the fundamentals you have outlined?

JK: Predicting biotechnology cycles has been close to impossible. The sector performed well in the late 1990s and early 2000s, and poorly in the late 2000s, and it has come back strong these past three years. The performance of the space seems correlated to both the overall economic conditions and macroeconomic policies. When there is more liquidity, and thus more easy money in the market, people tend to be increasingly willing to bet on the biotech industry, hoping that at least one of the companies they invest in will receive FDA approval for a drug that will become a blockbuster, in turn driving outperformance and revaluation of the originator company.

Despite the increase in success stories these last few years, just a small fraction of companies were developing new drugs. While a large portion of recent outperformance has come from successful drug innovation and higher FDA approval rates, it also resulted from favorable monetary policy. As monetary policies may shift, this could dampen enthusiasm for biotechnology companies.

This ties into a concern about whether the sector has the ability to retain investor interest and confidence. Further events that could trigger weakness across the sector include price controls for what some people deem expensive therapies [such as Gilead's Sovaldi], the pace of innovation and the outcomes of clinical trials, such as Vertex Pharmaceuticals Inc.'s ($VRTX) combination trials in cystic fibrosis. Clinical failures, slowing industry growth and increased regulatory risk remain factors to watch as new targeted therapies with high efficacy rates and fewer side effects also progress to the marketplace.

TLSR: Thank you for your time and comments.

Jason Kolbert has worked extensively in the healthcare sector as product manager for a leading pharmaceutical company, as a fund manager and as an equity analyst. Prior to joining Maxim Group, where he is head of healthcare research, senior managing director and biotechnology analyst, Kolbert spent seven years at Susquehanna International Group, where he managed a healthcare fund and founded SIG's biotechnology team. Previously, Kolbert served as the healthcare strategist for Salomon Smith Barney. He is often quoted in the media and is a sought-out expert in the biotechnology field. Prior to beginning his Wall Street career, Kolbert served as a product manager for Schering-Plough in Osaka, Japan. He received a bachelor's degree in chemistry from State University of New York, New Paltz, and a master's degree in business administration from the University of New Haven.

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